Small businesses that build large construction projects, such as bridges, roadways and large buildings, must make a choice as to how to account for these projects. Under accrual accounting, companies may proportionally recognize the revenue for these contracts as the job is completed. However, cash-basis accounting and the completed-contract method require the business to finish the job before recognizing revenue. Understanding some of advantages of these accrual-based systems can help you determine if an accrual-based revenue recognition policy is right for your company.

Performance Assessment

One of the biggest advantages of using accrual accounting for large construction projects is the ability to examine company performance using accounting metrics. Accrual accounting rules allow for the recognition of revenue on long-term contracts using the milestone method. Under the milestone method, a company books a portion of revenue related to the project as it meets certain milestones. Milestones must be substantive events occurring during the construction project and can't simply be the passage of time. For example, if your company is building a bridge and elects the milestone method, you may decide that it would make sense to recognize 25 percent of the contract revenue when the old bridge is demolished, 25 percent when the pilings are laid, 25 percent when the road deck is complete and 25 percent when the project is finished. You can then gauge the profitability of the project by comparing the planned expenses and revenues vs. the actual expenses and revenues at each milestone completion.

Periodic Payments

Even though the milestone method provides guidance on when to book revenues, not collect cash, companies that elect the milestone method and set these milestones into their contracts with customers often have an easier time setting periodic payment dates with their customers. By disclosing milestones to your customer, you will have checkpoints where it is reasonable to expect partial payment. Customers may be hesitant to agree to pay on a monthly or annual schedule if your payment is not tied to how much work you have completed. However, by making payments commensurate with progress, you are more likely to have your customers understand why they are making a payment for an incomplete project.

Representational Faithfulness

The accrual method of accounting for construction contracts more closely mirrors the actual economic reality of a long-term construction contract than the completed contract method. Under the completed contract method, you don't book revenue until you finish the project, regardless of any payments received during the construction process or the amount of work completed. However, accrual-based methods update the financial statements as work is completed. This makes the financial statements more faithfully represent what is actually going on.

Conservativism

The most common counterargument for the accrual method for large construction projects is that it isn't conservative enough. Under the milestone method, you book revenue when you meet the milestone, regardless of whether you have received payment. This could cause a situation where you complete an entire project, book revenue for the project and, in the end, only receive partial payment. This then requires you to adjust revenue going forward. Most small businesses only have the capacity to complete one or two of these contracts at a time. As such, customer nonpayment can cause large changes in reported revenue.

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About the Author

John Freedman's articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public company auditing and work with the campus recruiting team for his alma mater.